5-1 Bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the

e terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. A bond is a formal contract to repay borrowed money with interest at fixed intervals. Treasury bonds (T-Bonds, or the long bond) have the longest maturity, from twenty years to thirty years. They have a coupon payment every six months like T-Notes, and are commonly issued with maturity of thirty years. The secondary market is highly liquid, so the yield on the most recent T-Bond offering was commonly used as a proxy for long-term interest rates in general. This role has largely been taken over by the 10-year note, as the size and frequency of longterm bond issues declined significantly in the 1990s and early 2000s. A corporate bond is a bond issued by a corporation. It is a bond that a corporation issues to raise money in order to expand its business. The term is usually applied to longer-term debt instruments, generally with a maturity date falling at least a year after their issue date. A municipal bond is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, special-purpose districts, school districts, public utility districts, publicly owned airports and seaports, and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt. Foreign bonds are regulated by the domestic market authorities and are usually given nicknames that refer to the domestic market in which they are being offered. Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure. Par value, in finance and accounting, means stated value or face value. From this comes the expressions at par (at the par value), over par (over par value) and under par (under par value). In finance, maturity or maturity date refers to the final payment date of a loan or other financial instrument, at which point the principal (and all remaining interest) is due to be paid. The coupon or coupon rate of a bond is the amount of interest paid per year expressed as a percentage of the face value of the bond. It is the interest rate that a bond issuer will pay to a bondholder Coupon interest rate In bonds, notes or other fixed income securities, the stated percentage rate of interest, usually paid twice a year. Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a spread. The spread is a rate that remains constant. Almost all FRNs have quarterly

coupons, i.e. they pay out interest every three months, though counter examples do exist. At the beginning of each coupon period, the coupon is calculated by taking the fixing of the reference rate for that day and adding the spread A zero-coupon bond (also called a discount bond or deep discount bond) is a bond bought at a price lower than its face value, with the face value repaid at the time of maturity. It does not make periodic interest payments, or have so-called "coupons," hence the term zero-coupon bond. Investors earn return from the compounded interest all paid at maturity plus the difference between the discounted price of the bond and its par (or redemption) value. Examples of zerocoupon bonds include U.S. Treasury bills, U.S. savings bonds, long-term zerocoupon bonds, and any type of coupon bond that has been stripped of its coupons. Original Issue Discount (OID) is a type of interest that is created when a debt, usually a bond, is issued at a discount. Call provision A clause in a bond's indenture granting the issuer the right to buy back all or part of an issue prior to the maturity date. Redeemable bond A bond which the issuer has the right to redeem prior to its maturity date, under certain conditions. When issued, the bond will explain when it can be redeemed and what the price will be. In most cases, the price will be slightly above the par value for the bond and will increase the earlier the bond is called. A sinking fund is a fund established by a government agency or business for the purpose of reducing debt by repaying or purchasing outstanding loans and securities held against the entity. Convertible note is a type of bond that the holder can convert into shares of common stock in the issuing company or cash of equal value, at an agreed-upon price. Warrant --A derivative security that gives the holder the right to purchase securities (usually equity) from the issuer at a specific price within a certain time frame. Warrants are often included in a new debt issue as a "sweetener" to entice investors. The income bond is a somewhat rare financial instrument which generally serves a corporate purpose similar to that of preferred shares. It may be structured so that unpaid interest payments accumulate and become due upon maturity of the bond issue, but this is usually not the case; as such, it can be a useful tool to help a corporation avoid bankruptcy during times of poor financial health or ongoing reorganization. A Premium Bond is a lottery bond issued by the United Kingdom government's National Savings and Investments scheme. The government promises to buy back the bond, on request, for its original price. They were introduced by Harold Macmillan in his 1956 budget. The first winner was Ronnie Butters, a railway shunter working at Halifax; he was later to advertise Premium Bonds on television. A discount bond is a bond bought at a discount, or a price less than, its face value. The face value is the amount of money the holder of the bond receives at the

expiry date of the bond. Unlike coupon bonds, discount bonds only pay the bearer once, when the bond expires. The current yield, interest yield, income yield, flat yield or running yield is a financial term used in reference to bonds and other fixed-interest securities such as gilts. It is the ratio of the annual interest payment and the bond's current clean price The Yield to maturity (YTM) or redemption yield of a bond or other fixedinterest security, such as gilts, is the internal rate of return (IRR, overall interest rate) earned by an investor who buys the bond today at the market price, assuming that the bond will be held until maturity, and that all coupon and principal payments will be made on schedule. Yield to maturity is actually an estimation of future return, as the rate at which coupon payments can be reinvested when received is unknown Yield to call (YTC)--Yield on a bond computed on the basis of assumption that its issuer will redeem it at the first call date stated in the bond's prospectus (indenture agreement). It is a less precise and less complex method of yield than yield to maturity. The risk resulting from the fact that interest or dividends earned from an investment may not be able to be reinvested in such a way that they earn the same rate of return as the invested funds that generated them. For example, falling interest rates may prevent bond coupon payments from earning the same rate of return as the original bond. Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration.

Asset liability management is a common name for the complete set of techniques used to manage risk within a general enterprise risk management framework.
Default risk --The

risk that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. To mitigate the impact of default risk, lendors often charge rates of return that correspond the the debtor's level of default risk. The higher the risk, the higher the required return and vice versa

I. Indentures; mortgage bond; debenture; subordinated debenture

A bond secured by a mortgage on a property. Mortgage bonds are backed by real estate or physical equipment that can be liquidated. These are usually considered high-grade, safe investments. If an issuer in default has both secured and unsecured bonds outstanding, secured bondholders are paid off first, then unsecured bondholders. Naturally, because unsecured bonds carry greater risk than secured bonds, they usually pay higher yields.

Debentures are generally freely transferable by the debenture holder. Debenture holders have no voting rights and the interest paid to them is a charge against profit in the company's financial statements. A Subordinated debenture (also known as subordinated loan, subordinated bond, subordinated debt or junior debt) is debt which ranks after other debts should a company fall into receivership or be closed. Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. Subordinated debenture has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy, below the liquidator, government tax authorities and senior debt holders in the hierarchy of creditors.

J.. Development bond; municipal bond insurance; junk bond; investment-grade bond

Bond issued by a government to raise financing for funding one or more specific projects or development work in geographic area. A group of insurance companies which insure payment of principal and interest on certain bonds. These are usually purchased for speculative purposes. Junk bonds typically offer interest rates three to four percentage points higher than safer government issues. Bond insurance is a service whereby issuers of a bond can pay a premium to a third party, who will provide interest and capital repayments as specified in the bond in the event of the failure of the issuer to do so. The effect of this is to raise the rating of the bond to the rating of the insurer; accordingly, a bond insurer's credit rating must be almost perfect. --A bond which is relatively safe, having a high bond rating such as BBB or above.
Investment-grade bond

K. Real risk-free rate of interest, r*; nominal risk-free rate of interest, rRF

The risk-free interest rate is the theoretical rate of return of an investment with zero risk, including default risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a given period of time The "real interest rate" is approximately the nominal interest rate minus the inflation rate. It is the rate of interest an investor expects to receive after subtracting inflation. This is not a single number, as different investors have different expectations of future inflation. If, for example, an investor were able to lock in a 5% interest rate for the coming year and anticipated a 2% rise in prices, it would expect to earn a real interest rate of 3%

L. Inflation premium (IP); default risk premium (DRP); Liquidity; liquidity premium(LP)

Return on an investment over its normal rate of return. Investors seek this premium to compensate for the erosion in the value of their capital due to inflation. Default risk premium (DRP); The portion of a nominal interest rate or bond yield that represents compensation for the possibility of default It is safer to invest in liquid assets than illiquid ones because it is easier for an investor to get his/her money out of the investment. Liquidity premium is a term used to explain a difference between two types of financial securities (e.g. stocks), that have all the same qualities except liquidity. Interest rate risk is the risk (variability in value) borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa. Interest rate risk is commonly measured by the bond's duration. Maturity risk refers to the risk that is associated with uncertainty of interest rate. According to Financeglossary.net, the amount of the premium depends on the maturity of the bond. The longer it takes, the higher the amount of premium. Reinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available. This primarily occurs if bonds (which are portions of loans to entities) are paid back earlier then expected. The term structure of interest rates, also known as the yield curve, is a very common bond valuation method. Constructed by graphing the yield to maturities and the respective maturity dates of benchmark fixed-income securities, the yield curve is a measure of the market's expectations of future interest rates given the current market conditions. Treasuries, issued by the federal government, are considered risk-free, and as such, their yields are often used as the benchmarks for fixed-income securities with the same maturities. The term structure of interest rates is graphed as though each coupon payment of a noncallable fixed-income security were a zero-coupon bond that matures on the coupon payment date. The exact shape of the curve can be different at any point in time. So if the normal yield curve changes shape, it tells investors that they may need to change their outlook on the economy. In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and the time to maturity of the debt for a given borrower in a given currency. For example, the U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely watched by many traders, and are commonly plotted on a graph such as the one on the right which is informally called "the yield curve." More formal mathematical descriptions of this relation are often called the term structure of interest rates.

M. Interest rate risk; maturity risk premium (MRP); reinvestment rate risk

N. Term structure of interest rate; yield curve

O. Normal yield curve; inverted (abnormal) yield curve

This yield curve is considered "normal" because the market usually expects more compensation for greater risk. Longer-term bonds are exposed to more risks such as changes in interest rates and an increased exposure to potential defaults. Also, investing money for a long period of time means an investor is unable to use the money in other ways, so the investor is compensated for this through the time value of money component of the yield.

Inverted Yield Curve: These yield curves are rare, and they form during extraordinary market conditions wherein the expectations of investors are completely the inverse of those demonstrated by the normal yield curve. In such abnormal market environments, bonds with maturity dates further into the future are expected to offer lower yields than bonds with shorter maturities. The inverted yield curve indicates that the market currently expects interest rates to decline as time moves farther into the future, which in turn means the market expects yields of long-term bonds to decline. Remember, also, that as interest rates decrease, bond prices increase and yields decline. (5-2) A change in the interest rate of a 90 day T-bill would only influence the price for one quarter of a year. So if rates went up 1% on a 90 day bill you own you are facing losing the opportunity to make that extra 1% for one quarter so that would mean you lose only . 25% annual interest. You can buy a new one in 90 days at the new rate when yours matures. With a 30 year Treasury bill a 1% change would mean a loss, an opportunity cost, for the whole term or 120 quarters! So for the same *percentage* change in rates the 30 year rates the price would be 120 times more sensitive. But this is WHY the long term rates are less volatile because they try to predict the rates over a longer period because the price is more sensitive to the rates. There is a balance. Long term rates are less volatile but more sensitive. Short term rates are more volatile but the price is less sensitive because of the short time frame.

Problems 5-1 and 5-5 (5-1) Jackson Corporations bonds have 12 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8%. The bonds have a yield to maturity of 9%. What is the current market price of these bonds?

Recall the formula to find the bond price on the date of a coupon payment: P = F*r*[1 -(1+i)^-n]/i + C*(1+i)^-n, where ------------------------------------F = par value

C = maturity value r = coupon rate per coupon payment period i = effective interest rate per coupon payment period n = number of coupon payments remaining ---------------------An easy way to derive this formula is to note that the bond price is the present value of all coupons (first term in formula) + the present value of the maturity value (second term in formula) -----------------In this problem F = 1000. Since we are not given the maturity value, we can assume that it is the same as the par value. So, C = 1000. r = .08 i = .09 n = 12 Therefore, the bond price is 1000*.08 * (1 - 1.09^-12)/.09 + 1000*1.09^-12 = $928.39
(5-5) A Treasury bond that matures in 10 years has a yield of 6 %. A 10-year corporate bond has a yield of 9%. Assume that the liquidity premium on the corporate bond is 0.5 %. What is the default risk premium on the corporate bond?

It appears to me that: YTM-Liquidity-Risk free = default risk premium... YTM = 9% Liquidity = 0.5% Risk free = 6% 9%-0.5%-6% = 2.5%
Chapter 6: Questions 6-1, 6-2 and 6-3

(6-2) The

probability distribution curve for a completely certain return would be a straight line, since there is no variability in the returns. The shape of the probability distribution curve for a set of completely uncertain return would be a horizontal line, since there is infinite variability of returns.
(6-3) Security A has an expected return of 7%, a standard deviation of returns of 35%, a correlation coefficient with the market of -0.3, and a beta coefficient of -1,5. Security B has an expected return of 12%, a standard deviation of returns of 10%, a correlation with the market of 0.7, and a beta coefficient of 1.0. Which security is riskier? Why? Coefficient of variation security A= 35/7= 5 Coefficient of variation security B= 10/12=0.83 Based on the coefficient of variation security, Security A has a bigger coefficient of variation which means that it more riskier than the security B.

 Chapter 6: Problems 6-3 and 6-4 (6-3) Assume that the risk-free rate is 5% and the market risk premium is 6%. What is the expected return for the overall stock market? What is the required rate of return on a stock that has a beta of 1.2?

Expected return= risk free rate + Risk premium = 11 Rate of return on stock= Risk free rate + beta x( expected market return- risk free rate) =5%+1.2(11%-5%) =12.2%
(6-4) Calculate the stocks expected return, standard deviation, and coefficient of variation.

Demand for the Comps products Weak Below average Average Above average Strong

Probability of this demand occurring

Rate of return ri-r^ (ri-r^)^2 (ri-r^)^2Pi if this demand occurs 0.1 -50% -61.4 3769.96 376.996 0.2 0.4 0.2 0.1 1 -5 16 25 60 -16.4 4.6 13.6 48.6 268.96 21.16 184.96 2361.96 Variance 53.792 8.464 36.992 236.196 712.44

Expected rate of return= 0.1*(50) +0.2*(5) + 0.4*16+ 0.2*25+ 0.1*60 = (5) + (1) + 6.4 + 5 + 6 =11.4 Standard deviation=712.44=26.69% Coefficient variation=26.69/11.4 = 2.341